An
efficient capital market is a market where the share prices reflect new informations accurately and in real quick time. Capital market efficiency is judged by its efficiency of incorporating and inducting informations into prices of securities. The informations are generally about the basic value of securities. This basic or fundamental value of securities is the present value of the cash flows expected in the future by the person owning the securities.
The fluctuations in the value of stocks encourage traders to trade in a competitive manner with the objective of profit maximization. This results in price movements towards the current value of the cash flows in the future. The informations are very easily available at cheap rates because of the presence of organized markets and various technological innovations. An efficiency of capital market incorporates informations fast and accurately into the prices of securities.
In a weak-form efficient capital market informations about the history of previous returns and prices are reflected fully in the security prices. The returns from stocks in this market are unpredictable. In the semistrong-form efficient market, the public informations are reflected in totality in security prices. In this market, those traders who have non public information access can earn excess profits. In the strong-form efficient market, investors can under no circumstances earn excess profits because all informations get incorporated into the security prices.
The funds that are flowing in capital markets from savers to the firms with the aim of financing projects must flow into the best and top valued projects and therefore, informational efficiency is of supreme importance. Stocks must be efficiently priced. If the securities are priced accurately, then those investors who do not have time for market analysis would feel confident about making investments in the capital market. It was Eugene Fama, who was one of the earliest to theorize capital market efficiency. But empirical tests of capital market efficiency had began even before that.